Baker Hughes: Most Appeal in Oilfield Services?

Investors in Baker Hughes (NYSE: BHI) sent shares higher on Friday, despite the fact that the company announced a profit warning last Thursday. Investors were already well aware of the troubles in Iraq, which was the main reason behind the profit warning.

Update for the final quarterIn Baker Hughes' update for the final quarter of 2013, the company acknowledged that business disruptions in Iraq affected the fourth quarter results, as operations resumed at the end of last month.

Lost revenues from these operations, as well as additional incurred expenses, could impact earnings by some $80 million on an after-tax basis. The impact is estimated at $0.18 per share. On top of this, revenues from activities in the U.S. and the North Sea fell on the back of weather delays, putting pressure on operating earnings.

In light of these headwinds, non-GAAP earnings are seen between $0.60 and $0.62 per share. This estimate includes the $0.18 per share charge from the operations in Iraq, but excludes $0.06 per share in severance costs.

Note that definitive earnings are scheduled to be released as soon as Jan 21.

Diversified operationsBaker Hughes has diversified operations on a geographic basis as well as in terms of actual services being offered. Innovation allows the company to operate on the forefront of the industry while insulating the firm from one-time issues, such as the recent force majeure in Iraq.

The diversified range of offerings can be seen below. Note that North America continues to dominate the operations of Baker Hughes, generating half of total revenues. International revenues make up roughly 45% of revenues at the moment, as industrial services make up the remainder of sales.

source: company presentation

Unfortunately the fortunes of Baker Hughes and other oilfield service providers are tied to the price of oil in particular, as well as natural gas prices. Note that in the second half of 2008, when the world economy and oil prices fell off a cliff, shares of Baker Hughes lost more than half of their value in just a three month time period.

Long-term growth opportunityInnovation within oilfield services is increasingly becoming more important. One of the best known innovations is horizontal drilling, which significantly increases well productivity.

While costs of drilling continue to increase, especially at great depths, the role of firms like Baker Hughes becomes increasingly more important.

As oil remains highly relevant with demand still increasing, oil majors stand to make huge investments in the coming decades in their effort to meet demand. Firms like Chevron spend roughly $40 billion per annum to grow and maintain production. This implies that a firm like Chevron invests over $100 million per calendar day to achieve this objective. As can be seen in the below Baker Hughes investor presentation slide, greater capital expenditures are needed to grow oil production, resulting in greater demand for the services of oilfield suppliers.

Between 2009 and 2012, Baker Hughes has more than doubled its operations in terms of revenues, aided by the recovery of the world economy and the $5.5 billion acquisition of BJ services in 2010.

source: company presentation

ValuationBaker Hughes is a relatively small player in the oilfield service industry despite its rapid growth. With a market capitalization of $23 billion, its size is limited compared to some of its larger competitors.

Halliburton (NYSE: HAL) and Schlumberger (NYSE: SLB) are two larger competitors with market capitalizations two and five times that of Baker Hughes, respectively. Schlumberger, which is the industry leader, trades at the highest valuation multiples: 2.7 times 2012's annual revenues and 21 times earnings. Halliburton and Baker Hughes trade at lower and more acceptable earnings ratios of around 18 times earnings for 2012. Note that these competitors have seen rapid growth and margin expansion in recent years as well.

Given the smaller size compared to its two larger competitors, Baker Hughes trades at just 1.1 times annual revenues as its margins are structurally lower due to fewer scale opportunities.

Baker Hughes resorts to repurchases to please investors for now. It repurchased $350 million worth of shares during the fourth quarter, at a rate of 6% per annum. This compares to a very modest 1.1% dividend yield, and implies management might believe shares are undervalued.

Takeaway for investorsLong-term investors in Baker Hughes have seen excellent returns although they have trailed the performance of competitors Schlumberger and Halliburton on virtually all long-term time frames.

This has resulted in the slightly lower valuation as discussed above, especially versus its peers. In general the oilfield service sector typically trades at a premium given the long-term growth prospects, making it vulnerable to a major setback as seen in 2008. While the relative valuation is reasonably appealing, the absolute valuation is more than fair at 18 times earnings.

Within the sector, Baker Hughes is a top pick, especially for the long term.

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